Determine two to three
Determine two to three (2-3) methods of using stocks and options to create a risk-free hedge portfolio
I found the research of this question to be extremely interesting. The simplest form of purchasing securities in order to reduce portfolio risk is hedging. These securities are intended to have negative correlation to the remainder of our portfolio so that it can help offset any other potential losses in our portfolio.
We can hedge by buying a put option. We can buy stock with one put option with a strike of $25 and pay $2 dollars per share for four months of protection. No matter what happens we will get at least $25 dollar a share for our stock between now and the option expiration. We could also do the same stock purchase but with a weaker form of hedging by selling one call option with a strike of $40 that is good for four months. We receive $2 per share for selling the option. There is also a protective put trading strategy in which 1 contract of put options is purchased for every 100 shares. Put options will rise $1 for every $1 drop in the underlying stock. This hedges any loss sustained by the stocks.
So buying puts will guarantee us a floor price for our stock but may eat into our profits. Selling calls will generate income and give us a little protection but can also create a cap on our upside. Protective puts hedge against a drop in the underlying stock using put options. If our stock drops the gain in the put options will offset the less in our stock. Covered calls hedge against a small drop in the underlying stock by selling call options. It is the premium we receive from the sale of the call options that will buffer against any corresponding drop in the underlying stock. There is also a covered call collar which hedges against a large drop in the underlying stock using put options while simultaneously increasing profitability to upside through the sale of call options.
References:
I found the research of this question to be extremely interesting. The simplest form of purchasing securities in order to reduce portfolio risk is hedging. These securities are intended to have negative correlation to the remainder of our portfolio so that it can help offset any other potential losses in our portfolio.
We can hedge by buying a put option. We can buy stock with one put option with a strike of $25 and pay $2 dollars per share for four months of protection. No matter what happens we will get at least $25 dollar a share for our stock between now and the option expiration. We could also do the same stock purchase but with a weaker form of hedging by selling one call option with a strike of $40 that is good for four months. We receive $2 per share for selling the option. There is also a protective put trading strategy in which 1 contract of put options is purchased for every 100 shares. Put options will rise $1 for every $1 drop in the underlying stock. This hedges any loss sustained by the stocks.
So buying puts will guarantee us a floor price for our stock but may eat into our profits. Selling calls will generate income and give us a little protection but can also create a cap on our upside. Protective puts hedge against a drop in the underlying stock using put options. If our stock drops the gain in the put options will offset the less in our stock. Covered calls hedge against a small drop in the underlying stock by selling call options. It is the premium we receive from the sale of the call options that will buffer against any corresponding drop in the underlying stock. There is also a covered call collar which hedges against a large drop in the underlying stock using put options while simultaneously increasing profitability to upside through the sale of call options.
References:
References: Brigham, E. F., & Ehrhardt, M. C. (2014). Financial management (14th ed.). Mason, OH: South-Western Cengage Learning From the scenario, create a unique hypothetical weighted average cost of capital (WACC) and rate of return Brigham, E. F., & Ehrhardt, M. C. (2014). Financial management (14th ed.). Mason, OH: South-Western Cengage Learning